Traditional life insurance products are known in the art as “fixed” life insurance products. Fixed life insurance products offer a minimum guaranteed annual interest rate (referred to herein as an “annual guarantee”) on policy funds net of insurance and administrative charges. The insurance company generally invests a portion of the premium in fixed income securities such as bonds and mortgages. The yield on such fixed income investments determines a gross return from which product charges may be deducted to then calculate the policy credited rate and/or dividends. Regardless of the performance of the insurance company's investment in the fixed income securities, the credited rate and/or cash values of the fixed life insurance product cannot be less than a guaranteed minimum.
“Variable” life insurance products are also popular with consumers and are also well known in the art. Variable life insurance products generally allow the consumer to determine how the premium (net of insurance, administrative, and product spread charges) will be invested by directing the funds to various sub-account choices that are available within the product. These sub-account choices carry distinct risks, as there is neither an annual guarantee on the investment performance nor a guarantee of the principal allocated to the sub-accounts. Sub-accounts usually carry risks similar to those of equity or bond mutual funds, including the upside potential and downside risk to loss of principal.
“Index-linked” life insurance products are more recent introductions into the market. Such products typically provide an annual guarantee like that provided by traditional fixed insurance products. In an index-linked life insurance product, all or a portion of the product's account value may be eligible for index-linked earnings based on increases in a specified equity market index. An index-linked life insurance product is typically credited with the greater of the index-linked earnings rate or the annual guarantee (determined on a compounded basis over an established time period) on the applicable portion of the product's account value.
In administering the index-linked account within an index-linked life insurance product, an insurance company typically invests a portion of the premium in fixed income securities such as bonds and mortgages. The investment yield on such fixed income securities is referred to herein as the “investment budget.” A product spread, to cover expenses and profit, is usually deducted from the investment budget to determine the “crediting budget.” The principal on the fixed income securities supports the index-linked life insurance product's guaranteed principal.
Unlike traditional fixed life insurance products, where the crediting budget is credited to the product, the crediting budget in index-linked life insurance products is used to support the index-linked earnings rate. To do this, the insurance company may invest a portion of the crediting budget in a hedged investment designed to generate proceeds that support the index-linked earnings to be credited to the product. A hedged investment may take a variety of forms, but typically involves the purchase and/or sale of options in the equity market index. A hedged investment is typically structured to be out-of-the-money by an amount equal to the annual guarantee.
In order to ensure that it will be able to cover the amount of the annual guarantee, the typical insurance company does not invest the entire crediting budget in a hedged investment. Rather, the insurance company will set aside a portion (referred to herein as the “guaranteed return budget”) of the crediting budget to back the annual guarantee over the specified time period. For example, if the crediting budget is 6.5% and the annual guarantee associated with the index-linked life insurance product is 3%, the insurance company would typically deduct and set aside 3% per year as the guaranteed return budget. The balance of the crediting budget after deduction of the guaranteed return budget (i.e. a balance of 3.5%) is available as the hedged investment budget for purchase of index-linked hedged investments.
Thus, in prior index-linked life insurance products, the guaranteed return budget is credited back to the product each year in order to cover the annual guarantee and any yearly proceeds realized from the hedged investment are used to support any index-linked earnings that exceed the annual guarantee. The amount of index-linked earnings that can be supported through a hedged investment is obviously limited by the amount of the crediting budget that can be allocated to purchase the hedged investment. In other words, the larger the hedged investment budget, the greater the potential for index-linked earnings generated by the hedged investment, and the more attractive the index-linked crediting terms the insurance company can offer to its consumer. However, insurance companies have heretofore been unable to increase the hedged investment budget of an index-linked life insurance product without incurring significant risk that insufficient funds are set aside to cover the annual guarantee.
Accordingly, there remains a need for an index-linked life insurance product having a maximized hedged investment budget for purposes of generating maximum index-linked earnings, while maintaining a sufficient guaranteed return budget to cover the annual guarantee.